Shadow Banking Risks Exposed by Local Debt Audit: China Credit

China’s audit of local governments exposed an increased reliance on shadow banking, swelling the risk of default on 17.9 trillion yuan ($3 trillion) of debt.

Bank lending dropped to 57 percent of direct and contingent liabilities as of June 30 from 79 percent at the end of 2010, while bonds rose to 10 percent from 7 percent, National Audit Office data show. Trust financing surged to 8 percent from zero, while other channels that sidestep loan curbs accounted for the remaining 25 percent. The yield on five-year AA notes, the most common rating for local government financing vehicles, jumped by a record 158 basis points last year to 7.6 percent. That exceeds the 5 percent on emerging-market corporate notes, Bank of America Merrill Lynch indexes show.

“As banks tightened their purse strings, local governments had no choice but to resort to shadow banking and incur more expensive borrowing costs,” said Tang Jianwei, a Shanghai-based economist at Bank of Communications Co., the nation’s fifth-largest lender. “That will further constrain their repayment ability and eventually overwhelm some lower-level entities which have borrowed way beyond their means. I won’t rule out some defaults in 2014.”

Premier Li Keqiang is cracking down on less-regulated shadow banking activities, estimated by JPMorgan Chase & Co. at $6 trillion in May last year, while the central bank engineered a cash crunch in June 2013 to push deleveraging in the world’s second-largest economy. China’s borrowing spree since 2008 has evoked comparisons to debt surges that tipped Asian nations into crisis in the late 1990s and preceded Japan’s lost decades.

Credit Negative

The increase in government debt as revealed in the audit is a credit-negative development, Moody’s Investors Service said in a report dated Jan. 2. “This sizable accumulation in local government debt will be a burden on the carry risks to central government finances,” it said.

Local government debt overdue at the end of June was 1.15 trillion yuan, or 10.56 percent of borrowings, the audit report showed. That compares with the 1.3 percent overdue ratio in the banking system, reflecting the practice of rolling over regional debt instead of classing it as delinquent, according to Barclays Plc.

“Rapidly rising local-government debt poses the biggest medium-term fiscal risks,” Chang Jian, a Hong Kong-based economist at Barclays, wrote in a Dec. 31 note. “Intertwined with the under-regulated and poorly managed shadow banking business, slowing economic growth and more liberalized markets, systemic financial risks are increasing.”

Loans Capped

The China Banking Regulatory Commission estimated in 2010 that about half of the bank loans to LGFVs were being serviced by secondary sources including guarantors because the ventures couldn’t generate sufficient revenue, according to a person with knowledge of data collected by the nation’s regulator. In 2012, the agency suggested banks cap loans to such vehicles to levels reached at the end of 2011. CBRC Chairman Shang Fulin reiterated the limit last month.

As a result, growth in bank loans to local governments slowed to 19 percent to 10.1 trillion yuan from the end of 2010 to June 30, 2013, compared with a 67 percent jump in total debt, audit data showed. Trust financing to LGFVs surged to 1.4 trillion yuan from zero and bond issuance more than doubled to 1.8 trillion yuan.

Asset Quality

As asset quality concerns on loans to LGFVs has been a major valuation overhang for Chinese banks, the outcome from the recent national audit on local government debt is positive for banks, Simon Ho and Paddy Ran, analysts at Citigroup Inc. wrote in a report on Jan. 3.

China’s local governments are responsible for 80 percent of spending while getting about 40 percent of tax revenue, the legacy of a 1994 tax-sharing system, according to the World Bank. Local governments have set up more than 10,000 financing vehicles to fund projects such as subways and airports because regulations limit their ability to borrow money directly.

Deprived of relatively cheaper loans from banks, some LGFVs are paying more to borrow from trust companies. Local governments are normally charged more than 10 percent annually for funding from such sources, the official Xinhua News Agency reported in November. That compares with the People’s Bank of China’s 6 percent benchmark one-year lending rate.

Shanghai Chengtou Corp. sold the first onshore dollar-denominated bond by an LGFV, issuing $200 million of AAA rated notes with a 3.3494 percent coupon on Dec. 27, according to a statement on the website of the Shanghai Clearing House.

Trust Companies

Trusts typically get people to invest at least 1 million yuan in alternatives to bank accounts linked to the PBOC’s 3 percent benchmark deposit rate. They had 10.1 trillion yuan of assets under management as of Sept. 30, an increase of 60 percent from a year earlier, according to the China Trustee Association. About 26 percent of their proceeds were invested in infrastructure projects.

The National Development and Reform Commission will work to prevent default, fiscal and financial risks in LGFVs as 100 billion yuan of debt is estimated to come due this year, according to a statement posted on the agency’s website on Dec. 31. The special vehicles will be allowed to sell bonds at lower costs to refinance higher-cost borrowings, and the NDRC can approve new debt to finish projects short of funding, according to the statement.

Default Concern

“The top leadership is aware of the problem, and has already started to take action,” said Wang Ming, marketing director at Shanghai Yaozhi Asset Management LLP., which oversees 2 billion yuan of fixed-income investments. “The NDRC statement is meant to address the default concern.”

President Xi Jinping last year said the performance of regional officials will be measured by how effectively they control debt. There haven’t been any defaults in China’s publicly traded domestic bond market since the central bank started regulating it in 1997, according to Moody’s Investors Service.

The State Council has issued an order imposing new limits on shadow banking, two people familiar with the matter said. The new rules include banning transactions designed to avoid regulations such as moving interbank lending off balance sheets, said the people, who asked not to be identified because the order hasn’t been made public. The regulations were sent to ministries and local governments last month, the people said.

The Shanghai Composite Index of stocks slid 1.8 percent to 2,045.71 at the close today, its lowest since Aug. 8. The gauge has slumped 3.3 percent in the first three trading days of 2014, the worst start to a year since 2002, as gauges of manufacturing and services industries fell amid higher money-market rates. The securities regulator approved 11 initial public offerings for Shenzhen over the weekend.

Surging Yields

The yield on China’s 10-year sovereign bond surged about 100 basis points, or 1 percentage point, last year to 4.6 percent. The seven-day repurchase rate jumped to an unprecedented 10.77 percent on June 20, pushing the average rate in 2013 to 4.09 percent, up from 3.50 percent in 2012. The one-year interest-rate swap, the fixed payment needed to receive the repo rate, reached an all-time high of 5.38 percent on Jan. 2, 2014. The yuan, which advanced 2.9 percent in 2013, fell 0.02 percent to 6.0526 per dollar in Shanghai today.

Borrowing costs are climbing as regulators are freeing up interest rates. The nation started the trading of negotiable certificate of deposits last month, a sign that regulators will accelerate the liberalizing of rates, after the ruling party’s third plenary session in November decided to grant the market a “decisive” role in allocating resources.

“As the top decision makers attempt to free controls on interest rates, they understand a stable market environment is necessary to achieve the goal.” said Shanghai Yaozhi’s Wang. “As these LGFVs get implicit guarantees from the state, and considering the negative impact of any defaults from a government-guaranteed entity on markets, the government will certainly work hard to prevent that.”

— With assistance by Helen Sun, and Jun Luo

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